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21International Financial Management

Prepared by:

Michel PaquetSAIT Polytechnic

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Chapter 21 - Outline• Canadian Involvement in International Trade

and Capital Investment• Reasons for a Foreign Investment Decision• Risk Considerations in the Foreign

Investment Decision• Exchange Rates• Foreign Exchange Risk Hedging Techniques• Financing International Operations• Summary and Conclusions

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Learning Objectives

1. Identify reasons for a foreign investment decision (later analyze). (LO1)

2. Identify the effects of exchange and political risk on the foreign investment decision. (LO2)

3. Discuss the effects of exchange rates on the firm’s profitability and cash flow. (LO3)

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Learning Objectives4. Outline the factors influencing the exchange rates.

(LO4)5. Define spot and forward exchange rates and

compute forward premiums and discounts. (LO5)6. Evaluate techniques to hedge or reduce foreign

exchange risk. (LO6)7. Describe the purposes and nature of the

multinational operations of the corporation. (LO7)8. Outline potential ways to finance international

operations. (LO8)

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Figure 21-1World’s leading merchandise exporters, 2006

LO1

Source: www.wto.org. Top ten: 53% of world total of $14 trillion.

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Figure 21-2World’s leading merchandise importers, 2006

LO1

Source: www.wto.org. Top ten: 56% of world total of $14 trillion.

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Figure 21-3Canada’s 2007 merchandise exports and imports by region

LO1

Note: Exports $463 billion, imports $415 billion, GDP $1,497 billion.Source: Bank of Canada, “Banking and Financial Statistics”, August 2008, series J3.

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Figure 21-4Canada’s international balance of payments, current account, 2007

LO2

Source: Bank of Canada, “Banking and Financial Statistics”, August 2008, series J1.

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Figure 21-5Canada’s international investment position, 2007

LO2

Source: Statistics Canada, Catalogue No. 67-202, Table 1.

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Figure 21-6Canada’s investment abroad by region, 2007 (assets)

LO2

Source: Statistics Canada, Catalogue No. 67-202, Tables 3-10. (“Other” includes loans and deposits.)

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Figure 21-7Foreign investment in Canada by region, 2007 (liabilities)

LO2

Source: Statistics Canada, Catalogue No. 67-202, Tables 2-6. (“Other” includes loans and deposits.)

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Reasons for a Capital Investment Decision

• Higher potential returns- Lower production costs due to:

• resource availability and ease of exploitation • significantly lower wages

- Better revenues due to: • Larger and more concentrated markets

- Lower corporate income tax rates- Delayed Canadian taxes on income• Strategic advantages• Broader diversification possibilities

LO2

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Multinational Corporations (MNCs)

• Firm doing business in more than one country• Often 30% or more of a firm’s business

activities are carried out outside its national borders

• 4 basic forms of multinational corporations:1. Exporter2. Licensing Agreement3. Joint Venture4. Fully Owned Foreign Subsidiary

LO3

©2009 McGraw-Hill Ryerson Limited14 of 27 Number of stocks

20

40

60

80

100

10 20 30 40 50

International stocks

Canadian stocks

Risk (percent)

Figure 21-8Risk reduction from international diversification

11.7

LO3

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Risk Considerations in a Foreign Investment Decision

Political Risk:1. an unfriendly foreign government

blocks profit repatriation expropriate the foreign subsidiary’s assets

2. political risk assessment before making final decision3. strategies to guard against political risk

set up a joint venture with a local entrepreneur enter into a joint venture with firms from other countries obtain insurance in advance

Foreign Exchange Risk volatile foreign currency values lead to fluctuating value of an

international transaction or investment

LO3

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Exchange Rates• The exchange rate is the price of one currency in terms

of another• Published daily in the business press• Rates are determined by the supply of and demand for

each currency• Factors Influencing Exchange Rates:

– Relative Inflation Rates– Relative Interest Rates– Balance of Payments– Government Policies– Confidence in the Future Performance of the Economy

LO4

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Table 21-1Selected currencies and exchange rates (number of foreign currency units you can purchase with one Canadian dollar)

LO4

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Spot Rates and Forward Rates

Spot Rate:– the exchange rate between currencies for immediate delivery– “on-the-spot” rate

Forward Rate: – the exchange rate that is established for delivery at a specified

date in the future

12( )( )

Forward spotForwardpremium discountspot contractlength months

LO5

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Managing Foreign Exchange Risk Foreign Exchange Risk refers to the possible

change in value of foreign exchange rates.Types of Foreign Exchange Risk:

1. Economic Exposure: the market value of foreign currency-denominated assets and

liabilities is subject to change 2. Accounting or Translation Exposure

the amount of loss or gain resulting from the accounting treatment of foreign investments

3. Transaction Exposure the foreign exchange gains or losses resulting from realized

international transactions

LO6

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Foreign Exchange Risk Hedging Techniques

• Forward Exchange Market Hedge• Money Market Hedge• Currency Futures Market Hedge• Options Market Hedge

LO6

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The Multinational Corporation

• Exporter – produce locally and export to foreign markets

• Licensing Agreement – exporting firms grant a license to local producers to use the firms’ technology in return for a royalty or licensing fee.

• Joint Venture – establish a business partnership with a local foreign manufacturer

• Fully Owned Foreign Subsidiary – firms set up their own foreign operations

LO7

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Financing International Operations

There are several specialized financing arrangements for foreign transactions:– Letter of credit– Export Development Corporation– Loans from the Parent Company or a Sister Affiliate– Eurocurrency Loans– Eurobond Issues– International Stock Issues

– The International Finance Corporation (IFC)

LO8

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Canadian parent firm Dutch parent firm

Dutch firm’s affiliate Canadian firm’s affiliate

In Canada In the Netherlands$

loan

Gui

l der

l oan

Indirect loanIndirect loan

Figure 21-10A parallel loan arrangement

LO8

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Figure 21-11A fronting loan arrangement

Dutch affiliateAmsterdam bank

Canadian parent company

Deposits funds in

Lends funds to

LO8

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Table 21A-1Cash flow analysis of a foreign investment

Projected Cash Flows (millions ringitts unless otherwise stated)

Year 1 Year 2 Year3 Year 4 Year 5 Year 6

Revenues -Operating expenses

45.00 28.00

50.00 30.00

55.00 30.00

60.00 32.00

65.00 35.00

70.00 35.00

-Amortization 10.00 10.00 10.00 10.00 10.00 10.00 Earnings before Salaysian taxes 7.00 10.00 15.00 18.00 20.00 25.00 -Salaysian income tax (25%) 1.75 2.50 3.75 4.50 5.00 6.25 Earnings after foreign income taxes 5.25 7.50 11.25 13.50 15.00 18.75

= Dividends repatriated 5.25 7.50 11.25 13.50 15.00 18.75 Gross Canadian taxes (46% of foreign earnings before taxes)

3.22

4.60

6.90

8.28

9.20

11.50

-Foreign tax credit Net Canadian taxes payable

1.75 1.47

2.50 2.10

3.75 3.15

4.50 3.78

5.00 4.20

6.25 5.25

Aftertax dividend received by Q Systems 3.78 5.40 8.10 9.72 10.80 13.50 Exchange rate (ringitts / $) Aftertax dividend

2.00 1.89

2.04 2.65

2.08 3.89

2.12 4.58

2.16 5.00

2.21 6.11

PV of dividends ($) (at 20%) 1.58 + 1.84 + 2.25 + 2.21 + 2.01 + 2.05 = $11.94

APP-21A

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Summary and Conclusions• Canadian economy is highly open to the rest of world

through trade and capital investment.• International trade and investment are carried out by

multinational corporations (MNCs).• Lower production costs overseas, tax deferral

provisions, strategic advantages and benefits of international diversification are motives for MNCs to do business on a global scale.

• Together with higher returns from foreign investment come political risk and foreign exchange risk.

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Summary and Conclusions

• The rate at which one currency unit is converted into another is called the exchange rate.

• Volatile exchange rates result in economic exposure, accounting exposure and transaction exposure.

• Some hedging techniques are available for MNCs to reduce foreign exchange risk.

• Alternative sources available for MNCs to finance their international operations.